Katharina Cavano l Palladium - Nov 11 2020
Helping Investors Evaluate Corporate Sustainability: The Problem with ESG Ratings

Photo Credit: Hao dong

The field of impact investing continues to increase in popularity. Since the term was first coined in 2007, there are now over USD 500 billion in impact investing assets under management, according to the Global Impact Investing Network (GIIN). But as this investment trend gets its legs and more investors get involved, the need to value an organisation’s contributions to ESG (environmental, social, and governance) outcomes – alongside well-established methods for valuing financial performance – grows stronger.

To meet this need, an industry has cropped up to provide ESG ratings to institutional investors and individuals alike. These ratings look at a variety of inputs, including the company’s own reporting, and determine a rating to compare against peers and inform investment choices.

In principle, this should mean that if an impact investor wants to have a significant impact with compelling returns, they can find companies that have a traditional buy rating and an excellent ESG rating in which to invest.

Palladium’s David McMillan cautions that it’s not that simple. “ESG ratings are not yet telling a comprehensive story,” he says. “How do you reconcile the high ratings of many oil and gas companies with the mediocre rating of a renewable energy company? The ratings are difficult to compare.”
ESG ratings are highly inconsistent, and the slew of rating agencies out there often disagree on company performance.

In an attempt to mitigate the inconsistencies, the Sustainability Accounting Standards Board (SASB) has developed lists of material issues by industry (those ESG issues that are most relevant to the overall performance of the business). But even these ESG generalisations give us the false sense that sustainability efforts within an industry are easily comparable, McMillan explains.

“Despite SASB’s efforts, material issues do not vary purely based on industry but also on geography, target customers, business model, community, and more.”

The reality is that ESG ratings are a maturing tool. Given that each company’s ESG focus is understandably unique to its context, it is not surprising that ESG ratings are not always consistent.

“Perhaps ESG ratings, like buy/sell/hold ratings, will always be subject to the industry expertise and assumptions of the analyst as they evaluate the company’s strategy, assets, comments, and past results,” McMillan suggests, adding that despite the subjectivity of the matter, the opportunity for effective ratings still exists.

A Solution to Sustainability Ratings

There’s no magic bullet yet, says McMillan, and establishing consistent ways to value risk mitigation and impact will take time as organisations trial new measurements and share them with investors.

"ESG investments are not a cost centre, but rather a driver of long-term value creation."

As regulations increase, so will the maturation of the industry surrounding ESG ratings. There are various initiatives and proposals underway, such as the Impact-Weighted Accounts project and hybrid metrics that will link financial and ESG performance. These may soon provide a more standard accounting of ESG-adjusted performance, but consistent application will require wider adoption.

In the meantime, companies can do a few things independently to attract investors, starting with clearly communicating how ESG investments are not a cost centre, but rather a driver of long-term value creation. This means making the value of ESG clear externally and integrating it as a lens for investment internally – a task with which many companies struggle as they lack the tools to easily communicate the link between investments and results.

For these companies, McMillan recommends using a Strategy Map and the “Balanced Scorecard”, a methodology that was developed nearly 25 years ago to help businesses execute their corporate strategies. Since then, it’s been lauded as one of the most influential business ideas of the past 75 years, and is used by over 50% of Fortune 1,000 companies. McMillan and Balanced Scorecard co-creator Dr Robert S. Kaplan recently published an update for companies looking to achieve “triple bottom line” performance on ESG metrics.

“A Strategy Map’s architecture encourages clear cause-and-effect relationships,” McMillan explains, “while the measures and targets within the Balanced Scorecard include both financial and ESG outcomes, as well as the stakeholder perceptions and company activities that drive them.”

ESG ratings will continue to mature as investors increasingly demand insights into how businesses are addressing them. In the meantime, both investors and companies can supplement these blunt instruments by respectively looking for and demonstrating the linkage between sustainability investments and long-term results.

For more information on how these tools apply to a strategy that integrates ESG, read the Harvard Business School Working Paper “Updating the Balanced Scorecard for Triple Bottom Line Strategies”, co-authored by Palladium’s David McMillan and Balanced Scorecard co-creator Dr Robert S. Kaplan. Contact info@thepalladiumgroup.com for more information.